Will this high quality retailer defy the skeptics again?

For my first article I am focusing on well known retailer JB Hi-Fi (ASX:JBH). JB Hi-FI enjoys a StockRank™ of 98 which includes a Quality rank of 99. This will not come as a surprise to those who have followed the stock since it first listed in 2003, or indeed to anyone who has walked through a shopping mall in the last decade.

Despite the challenges of lockdowns, JB Hi-Fi, along with many other retail businesses, prospered during the pandemic as consumers had limited options to spend, with travel and entertainment greatly restricted, so instead they indulged themselves by buying stuff.

But now retailers appear to be facing tougher times. On the demand side, not only has the services side of the economy opened up, but consumer confidence looks like it may decline. Interest rates are rising and house prices are declining. This is expected to crimp demand as consumers need to tighten their belts.

On the cost side, wages are rising due to low unemployment and award wage increases of 4.6%, plus a 0.5% increase to superannuation, that came into effect in July. Rents are also rising as many are tied to CPI which was at 7.3% in the September quarter.

As a consequence of these forces, most market analysts are forecasting tough times ahead for the major retail stocks with reduced sales and increased costs leading to significant reductions in profits over the next two years.

JBH is now the second largest listed retailer in Australia outside the food sector, only surpassed by Wesfarmers. Revenue is A$9.2 billion and market capitalisation is A$4.9 billion. The business has been well run for many years, with revenue having increased every year for the last 10 years at an average compound rate of 11.4% per annum. Analysts are predicting that this streak of revenue increases will finally expire in 2023, but they have been wrong before.

Market analysts are forecasting revenue to ease slightly in 2023 followed by a fall of 2.5% in 2024. Two months ago the forecast declines were greater, so already the negativity is starting to moderate.

Profits are forecast to take a bigger hit than revenue. JB Hi-Fi trades on single digit net profit margins and even in the bumper year of 2022 only managed a margin of 8.4%. This means that small changes can make a big difference to the bottom line. As outlined, sales are expected to fall. In addition, gross margins are expected to contract as discounting is re-introduced to maintain market share and the cost of doing business is expected to rise due to increases in the cost base. Small changes in these three factors can lead to large changes in the bottom line.

Of course, this is all based on forecasts of what the economy is predicted to do over the next 12 to 18 months. Economic prediction is far from an exact science. Countering some of the negativity is record low unemployment, high savings rates, and pent up demand from having been locked in our closets for two years. Things may not turn out to be as bad as predicted. Or they could be worse.

Rather than obsessing about upcoming economic data, a better approach is to look out five years ahead and consider the likely prospects of the business. Could they continue to grow revenue above 10% per annum. Probably not, but a result half that good is still a good outcome. Given the strength of the business and its scale, if we do go through a tough period, they may be more resilient than their competitors and emerge with increased market share. They also have strong pricing power, so are more likely than some to be able to pass increased costs along to their customers.

JB Hi-Fi have managed their capital well. The balance sheet is strong with cash exceeding debt. The Bankruptcy risk is very low with a very safe Z2-Score of 5.6. They are also generating a return on equity of 42% with strong cash flow generation. In addition to increasing the dividend by 10% last year, they also returned $250 million to shareholders via an off-market buyback. These factors have contributed to their perfect Health score of 9/9.

Retailing is a cyclical business, fluctuating with the fortunes of the economy, however the good retailers ride through those periods and then look to prosper when the honey is flowing.

The $JBH share price has rallied since the lows in September. Despite that, the Value score is still high at 88. The forward PE ratio for 2023 is 11.2 as at 5 Dec 22 after allowing for a forecast 17% drop in EPS. The forward dividend yield, again assuming a 18% drop in dividends, is 5.8% fully franked. These represent quite attractive valuation metrics on their own. There could also be further upside, if the forecasts turn out to be overly pessimistic. Even if they are correct, in the longer term, if earnings revert back towards current levels and PE ratios return to their average levels then there is considerable upside for the share price.

Successful investing requires purchasing quality businesses for a good price. It also requires the patience to look through doom and gloom at the low point in the economic cycle. Could this company known for its bargain deals, represent a bargain for investors?

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